We have published a new IOI Tear Sheet on retail giant Wal-Mart (WMT). For additional color to the Tear Sheet, please read on.

The Wal-Mart Growth Story
Whenever I talk to an analyst covering Wal-Mart (WMT), they always crow about the company’s exposure to the quickly growing emerging economies and how this leads to Wal-Mart being able to turn in impressive growth numbers even being as large and mature as it is.

Indeed, the analysts must be paying close attention to what company management has been saying, since their comments are nearly verbatim to those of the corporate IR department… Here’s Wal-Mart’s president and CEO, Michael Duke’s comments regarding his firm’s International segment during the recent 4Q13 earnings call:

“International continues to be a growth engine for our company, delivering more than $135 billion in net sales for the year, including nearly $38 billion in the fourth quarter…”

What’s more, according to Duke, it’s not only sales that are growing, but shareholder wealth, as measured by free cash flow:

“Wal-Mart grew free cash flow by 18.1% to $12.7 billion…We also generated a return on investment of 18.2%.”

Imagine my surprise when I analyzed the financial statements and found that, even with the “high growth” foreign exposure, economic profits to shareholders have, over the past few years, accrued at about the same pace–some years a little faster, some years a little slower–than the overall U.S. economy!

The Numbers
IOI analyzes companies on the basis of the economic profit generated by a company. Economic profit is not a number reported on any single set of financial statements and is never mentioned in conference calls or on CNBC.

We will publish another post describing how IOI estimates the economic profit generated by a firm, but for those of you with an accounting background, it works out to operating cash flow less some allowance for maintenance capital expenditures. Here is IOI’s estimates of the economic profits generated by Wal-Mart’s business over the past few years:

Source: IOI, LLC Analysis
Wal-Mart (WMT) Estimated Economic Profit (EP) and EP Margin
Source: IOI, LLC Analysis

The red line (associated with values on the left-hand axis) shows a nicely growing stream of economic profits. The green line (values on the right-hand axis) shows the percentage of economic profit per $1 of revenues. It is pretty steady at between 3.5% and 4.5%, with most years right around that 4% mark–not unusual profitability for a discount retailer.

Let’s turn now to the growth rates of the profits, because when one sees profits growing, it is sensible to try to figure out if that growth is faster or slower than other companies growth over the same period. Rather than trying to find comparables for every company we analyze, we prefer just to compare a company’s growth in economic profits to the growth in domestic GDP–a measure of the “profitability” of the economy overall.

Doing this for Wal-Mart, here is the graph we get:

Source: IOI, LLC Analysis
Wal-Mart (WMT) Marginal Economic Profit vs. GDP
Source: IOI, LLC Analysis

The red line bouncing above and below $0 on the y-axis means that some years the firm generates profits greater than might be expected if their profits grew exactly at a rate equivalent to U.S. GDP and some years less. Looking over the entire series, Wal-Mart’s marginal economic profit is net positive, but over the past six years, it has swung net negative. All in all, looking at these data, it is hard for us to assume profit growth at Wal-Mart will be that much different from GDP in the future.

Why Growth Rates Matter
Corporate valuations are done in stages. There is a near-term stage that an analyst forecasts a firm’s wealth generating capacity in an explicit, detailed way. After that explicit period, an analyst generates a “terminal value”, which is a mathematical simplification that allows the analyst to assume a company will grow forever at a given rate. For new companies, there may be an intermediary period during which time an analyst calculates growth of profits at an above-trend growth rate.

The dirty little secret behind corporate valuations is that while 99% or more of an analyst’s  time is spent on the near-term explicit forecast, in most cases, the majority of the value of the firm lies in the “out years” as part of the terminal value. If a company can be reasonably expected to grow at above-trend growth in the future, the amount of value contained beyond the explicit period shoots up to 70% or more.

Considering the importance of these out-year growth rates, it seems counter-intuitive that analysts–even good ones–tend to pick terminal values in an almost casual way and with little rational basis.

Of course, company managers always make it a point to impress upon investors that their companies are not in the mature phase of their businesses, but have many more years of above trend growth ahead of them. Wal-Mart managers are, we believe, doing just this when they tout there overseas exposure.

What about Free Cash Flow?
Value investors love free cash flow and look to that measure to decide whether to pull the trigger on a new investment. Wal-Mart’s management specifically mentioned the robust growth in free cash flow the firm has generated–is IOI ignoring that free cash flow?

In a word, No.

IOI does analyze economic profit to develop a reasoned opinion on the terminal value, but at the end of the day, we base our valuations on free cash flow. The only wrinkle to that is that we do not use the value for free cash flow that management spoon feeds the investing community unless it happens to match ours (and it usually does not).

In Wal-Mart’s case, the firm overestimates its free cash flow in part by ignoring money spent on acquisitions as a deduction from free cash flow. This may seem like an academic point, but consider the following.

Wal-Mart is basically a grocers. There are precisely two ways for a grocer to increase sales:

  1. sell more groceries
  2. buy another grocer

Wal-Mart proudly announces revenue increases based on the former while conveniently not calculating in the costs of the latter into the free cash flow number they publish. No matte
r how you look at it–academically or practically–this does not make sense.

The valuation you will find in the recent IOI Tear Sheet for Wal-Mart is based on a true measure of free cash flow and a terminal value based on a rational, quantitative estimation of likely future growth.

Happy reading!